Daniel R. Siegel

Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases

This paper extends financial option theory by developing a methodology for the valuation of claims on a real asset: an offshore petroleum lease. Several theoretical and practical problems, not present in applying option pricing theory to financial assets, are addressed. Most importantly, we show the necessity of combining option pricing techniques with a model of equilibrium in the market for the underlying asset (petroleum reserves). The advantages of this approach over conventional discounted cash flow techniques are emphasized. The methodological development provides important insights for both company behavior and government policy. Promising empirical results are reported.

Investment and the Valuation of Firms When There is an Option to Shut Down

An important lesson from elementary microeconomics is that a plant should be shut down if operating revenues are less than variable costs. This simple production rule has implications -which have received little attentionfor the initial decision to build the plant.2 This paper develops and studies a methodology for valuing risky investment projects, where there is an option to temporarily and costlessly shut down production (with no effect on future prices and costs) whenever variable costs exceed operating revenues. It is obvious that future revenues or costs must be uncertain if the shut-down option is to affect the investment decision otherwise, it is always known ex ante whether the plant is to be operated. Uncertainty is introduced in this paper by supposing that prices and costs follow a continuous time stochastic process.3 The firm in our model is a risk-neutral, price-taking value maximizer, which is owned by risk-averse investors. Risk aversion thus influences the investment decision by affecting the cost of capital faced by the firm. This is in contrast to the model in Sandmo [1971], in which the firm maximizes the utility of profits.4 Our treatment is descriptive of value-maximizing, publicly-owned firms and is widely used in the finance literature. The economics literature studying the effect of uncertainty on firm behavior has, however, tended to follow Sandhmo. The explicit modelling of the shut-down option and our treatment of risk aversion give us results that differ from those obtained by others who have studied the valuation of risky projects. Our principal results are: 1) Increases in the variance of the output price can either raise or lower the

The information content of equity-for-debt swaps : An investigation of analyst forecasts of firm cash flows

Abstract We demonstrate that analysts revise their forecasts of net operating income downward following the announcement of an equity-for-debt swap. Their revisions are positively correlated with the size of the stock-price reaction to the swap announcement. This evidence supports the hypothesis that announcements of equity-for-debt swaps convey information about the expected level of cash flows of the firm. We also provide evidence that this information is about transitory changes in the expected cash flows.

The Use of Changes in Equity Value as a Measure of the Information Content of Announcements of Changes in Financial Policy

Recent work uses the change in equity value surrounding an announcement of a change in financial policy as an explanatory variable in regressions that examine whether changes in financial policy convey information about firm performance. We explore the methodological and econometric issues of this approach and show that using the change in equity value as an explanatory variable can severely bias ordinary least squares estimates. We demonstrate the effect of this bias on standard statistical tests and conclude that the bias has a significant impact on the power of these tests. We propose an estimator to partially correct the biases.

Failure of the Net Profit Share Leasing Experiment for Offshore Petroleum Resources

A current trend among oil-producing nations with private oil sectors is to move toward tax systems that are based upon pr ofits rather than production. The authors present a case study of wha t can go wrong with profit-based tax schemes. They study the implemen tation of the net profit share leasing system in the United States in the early 1980s. They conclude that the information requirements of the scheme are heavy, perhaps prohibitive, and that the net profit sh are system can easily backfire if the informational requirements can not be met. The authors also show that the U.S. government misused th e limited amount of information that was available to it. Copyright 1988 by MIT Press.